A story in yesterday's Business section incorrectly stated the number of hours of prime-time advertising required to equal $3.5 billion. The approximate number is 145.
When Capital Cities Communications Inc. agreed to buy American Broadcasting Cos. Inc. last week for more than $3.5 billion -- the cash equivalent of 18 hours of prime time advertising -- it proved once again there's no business like show business.
The first takeover of a major television network is the most dramatic event yet in the recent frenzy of media mergers that has also sparked record prices for newspaper, magazine and radio properties. Media company stock prices continue to skyrocket amid rumors of even more takeovers.
While some of the recent activity in media stocks is sheer speculative energy, there also has been a major shift in the way the stock market values media companies.
"The media business overall is a marvelous business," said Warren Buffett, a highly regarded investor who helped put together the Capital Cities acquisition of ABC and is investing more than $500 million in Capital Cities as a result of the deal. "It has among the very best economics in the business world."
Wall Street has discovered the hidden value of media companies: their remarkable ability to churn out cash.
Why is the cash flow of media companies a better yardstick for investors than pure profits? One reason is that the real profits of the most acquisitive and successful media companies are frequently reduced by accounting rules that require certain noncash expenses, such as depreciation, to be listed on a company's books.
By lowering the reported profits in this way, these noncash expenses mask the true value of many newspaper and television companies.
"Investors in the stock market are starting to see the values that have been apparent to investors in the private merger market for these companies," said Morgan Stanley investment banker Steven Rattner. "The discrepancy in value arises because the stock market tends to look to a greater extent at reported net earnings, which frequently are not the true measure of the value of these properties.
"Cap Cities' net income will suffer great dilution from acquiring ABC. Is Cap Cities worth less after acquiring ABC than before? Of course not," Rattner said.
"I don't think that the investment community has really understood the business," said John Backe, former chief executive officer of CBS Inc. and now chairman of Backe Communication Inc., a company that acquires television stations. "People were looking at assets instead of cash flow. Simply stated, much of the appeal of these companies is the high pretax flows capable of supporting a lot of debt."
That gives media companies tremendous financial flexibility -- especially at a time when interest rates are declining -- and that enhances their value.
The cash-generating potential of media companies is not the only factor in their dramatic popularity, however. New regulatory and financial forces also are making them more valuable today than they ever have been before.
The Reagan administration's relatively benign attitude to mergers and acquisitions leaves companies less jittery about antitrust litigation. This has had a special impact on the media industries. The general loosening of antitrust restrictions makes it possible for big companies such as Capital Cities, which already own television stations and newspapers, to acquire media giants such as ABC. There is no sign of opposition to this deal on antitrust grounds from the Justice Department, the Federal Trade Commission or the Federal Communications Commission.
The Reagan administration, in general, has indicated that "bigger isn't bad." Moreover, the FCC, has approved a new policy that allows media companies to own as many as 12 television stations instead of the previous maximum of seven. The rule change has led to several broadcast mergers with more expected, said Jeff Epstein, an investment banker at First Boston Corp., which advised ABC in the Capital Cities deal.
"The FCC rule change was the catalyst for these dynamics," Epstein said, "but these values have been going up for 10 years. With the Cap Cities-ABC deal and the high profile of a network, there has been a public visibility attracted to this industry in the last week which has never been there before."
The value of the companies has been further increased because of their often unique positions in the markets they serve. Many newspapers and television stations are regarded as unregulated, "minimonopolies" within the geographic areas they dominate.
"Why do people pay 25 times net income for these businesses?" Morgan Stanley's Rattner asks.
"They are monopolies. . . . A daily newspaper is an unregulated monopoly, and a result of that, these properties have been able to produce growth in revenue and profitability that you don't see in many other businesses. A good monopoly newspaper has 25 percent plus operating margins, and a good TV station in a major market goes above 40 or 50 percent. That is very attractive."
"They operate almost as a franchise business, if you will," said Backe. "Newspapers have a franchise in a community, and so do radio and TV stations."
With a restricted amount of broadcast frequencies available for local VHF TV stations, and market characteristics that have made it difficult in most cities to support more than one financially strong newspaper, these properties take on the characteristics of protected franchises. "They don't make 'em anymore," Rattner said.
Similarly, local television stations -- particularly network affiliates -- have enjoyed double-digit growth for many years as they've piggybacked on the tremendous rise in television advertising levels.
Fears that cable television and videocassette recorders would eat away at broadcast profitablity have sharply diminished as families are spending more time than ever before in front of the tube. As a result, local television stations are seen as a solid acquisition with enormous cash flow potentials.
Magazines, too, with their mix of loyal advertiser franchise and readership franchise, are seen as particularly good investments. The sale of several magazine companies recently has brought record prices.
Time Inc. recently agreed to acquire Southern Progress Corp., publisher of Southern Living magazine, for $480 million. S. I. Newhouse Jr. offered to buy the New Yorker magazine for $142 million, while the Ziff-Davis publishing empire was divided between CBS Inc., which acquired 12 consumer magazines for $362.5 million and Australian press baron Rupert Murdoch, who agreed to acquire Ziff's business and trade publications for $350 million.
Some public media companies have been acquired by their own managements and been taken private in leveraged buyouts, the largest of which was the $1.13 billion buyout of Metromedia Inc., the giant broadcasting company that owns WASH-FM and WTTG-TV, Channel 5 in Washington. Metromedia was purchased by its own management, who believed the company was worth considerably more than its stock market value.
Loyal advertisers are important to the magazines that have been sold for premium prices. Indeed, the growth of advertising dollars directly correlates with the rise in media values.
"This is a consumer economy," said Buffett, "and the best way to reach it is through advertising. For a national advertiser, the best way is through television in general and network television in particular. For a local advertiser, the outlet is the local newspaper."
As the rising tide of advertising expenditures lifts all media, those companies are prospering now more than ever before.
"Advertising as a percentage of GNP has been rising. In 1975, it was around 2 1/4 percent of GNP and now it is around 3 percent of GNP," said Epstein.
"Every time you add a dollar of GNP, you add two to three cents of advertising. If you have a media business with a stable cost base and GNP rises, you get a free ride," he said.
"Businesses which rely on advertising are great businesses. In the newspaper business in particular, there also have been enormous technological improvements resulting in lower operating costs, and it takes many fewer people to typeset a page of newsprint today than it did 20 years ago. The profit margins are substantially in excess of other American industries."
Compared with industries such as steel and automobiles, which face stiff foreign competition and find it difficult to pass along costs to customers in an inflationary environment, media companies fare well when there is significant inflation.
"The inflation of the 1970s was a strong wind at the back of the media companies," said Buffett, who also serves on the board of directors of The Washington Post Co. "Media properties relative to other properties do better in inflationary times."
"One of the things the media demonstrated is that, even in the down times, it seems to deliver," said Joseph Dionne, chief executive officer of McGraw-Hill, the diversified media company that owns several television stations and dozens of magazines, including Business Week. "If there is a return of inflation, the media have demonstrated the ability to pass along price increases better than other industries."
Part of that is the result of the quasi-monopolistic strength of various media properties and the ability of a media company's revenue, mostly from advertising, to keep pace with inflation. Costs, about half of which are fixed-interest expenses, only go up half as fast.
As interest rates have declined over the past 18 months, media prospects seem even brighter. But if inflation does come back, Dionne and Buffett note, media companies are superbly positioned to do well.
Another aspect contributing to the high prices for media properties has been the decision by the successful, cash-rich companies already in the businesss to avoid diversifying into nonrelated business -- as the steel and oil companies did.
Instead, these companies have "stuck to their knitting" and acquired additional media properties. The laws of supply and demand take hold as multiple buyers bid up prices for the limited amount of properties available.
In some cases, media companies, such as The Washington Post Co., are using some of their cash to repurchase their own stock, because in this market, the value is likely to rise.
There's a defensive quality to that strategy as well amid the takeover flurry, one broadcast company executive points out: "You increase capitalization by buying your own stock -- which ups earnings per share, which makes your shareholders happy."
It also keeps management happy because they fear an undervalued stock that could attract unwelcome suitors, the executive said. "You do not want people climbing into bed with you whom you don't want to sleep with," he added.
However, Backe and other observers warn that there is a large quality of trendiness to the recent flurry of media activity. "It's the herd instinct," he said.
"As I look at the whole situation, 50 percent of what's going on is a basic revaluation of value, 30 percent to 40 percent is frenzy, and the remainder is the positive environment we're in now."
He and others warn that, if some of the deals don't pan out, and if investors' expectations turn sour, the now high-flying media stocks could tumble.